How can consumer staples companies build and maintain a competitive moat? – ValueWalk Premium

How can consumer staples companies build and maintain a competitive moat?

Erin Lash is the Director for Consumer Equity Research at Morningstar Inc. She specializes in the sector of consumer staples (foods, household and personal care companies). Erin Lash has been working as an equity analyst since 2006. She was very kind to answer quite a few of my questions on consumer staples.

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How frequently do consumers switch consumer staples products, and is there a common cause to that behavior? 

There are no meaningful switching costs for end consumers. But leading players maintain the resources to support their brands at the shelf and defend their share position against the encroachment of smaller foes. We view marketing as a cost of doing business (not a source of competitive edge), since even value-added new products can fail if consumers don't know about them. However, this differentiates brands from private-label fare, where innovation and ad spend are deficient. Firms competing in commodity-like categories (where products turn fast and are often perishable, like meat and dairy) generally are price-takers with minimal differentiation and fail to garner an economic moat.

In our view, strong brands should allow manufacturers to consistently raise prices above the weighted average consumer price index in its geographic footprint (assuming a business-to-consumer business model). We believe this would indicate that a brand is increasing its share of wallet and passing cost inflation upstream. However, we surmise that it’s important to differentiate between real brand equity and trademark familiarity, as brand owners could maintain large, but ineffective, marketing budgets; we don’t believe merely elevating the level of brand spending correlates with increasing revenue growth. We assess brand strength through the lens of the Morningstar CPG Manufacturers Brand Strength Framework, a multitier test that scores businesses based on pricing power, the conspicuousness of consumption of the products, the risk aversion of the consumer to trying unbranded products, and industry structure.

Given the highly competitive landscape, we view efforts to consistently bring new products to market as essential but recognize any potential benefit from such investments can prove fleeting. We think the inability to realize sustainable gains stems from the rapid pace at which competitors can replicate innovation, making it difficult and at times cost-prohibitive to continually stand above peers and startups (which have proven more agile in responding to evolving consumer trends). Exacerbating these pressures, the shift online (and subsequent disintermediation of brick-and-mortar retailers) has lowered the barriers to entrants at a time when consumers are increasingly willing to experiment with unfamiliar brands, which in some categories (like snacks and organics) have gained share (at the expense of large, branded operators).

How can consumer staples companies build and maintain a competitive moat? 

Economic moats in consumer products stem from intangible assets and/or cost advantages. However, within intangible assets, we see two distinct potential advantages, of which firms can enjoy one or both: brand strength and retailer relationships. In our view, firms with higher market share in a niche tend to enjoy greater negotiating power over retailers, subsequently higher pricing power, and generally stronger brands. Overall, we believe stronger brands should lead to higher long-term sales growth, resulting from better pricing power versus peers and stable or improving volume share positions. The more concentrated an industry, the more likely pricing dynamics are to be rational. Further, we surmise pricing power--and by extension brand strength--is fairly limited to categories where the consumption of the product is conspicuous, like cosmetics, which are often given as gifts. Pricing power is also strong where consumers have an aversion to taking a risk on an unfamiliar product (such as infant formula, pet food, and consumer health), as the perception of downside risk to untested products makes brand recognition highly influential in the purchasing decision and keeps pricing power strong. Further, we believe supply-chain entrenchment creates a virtuous cycle, beginning with scale, that gives the manufacturer a symbiotic relationship with retailers. The greatest challenge facing consumer goods manufacturers is finite shelf space and distribution capacity in traditional grocery. Category leaders can gain and retain shelf space by deploying category captains to share local and category-level data with retailers. This is a mutually beneficial relationship where the vendor becomes an important retail partner, developing sales strategies to maximize volumes and retailers’ margins, while at the same time prioritizing its own brands.

What types of individual behavioral economic biases impact a consumer’s decision to stick with a certain company's products or switch? 

As I mentioned in the prior question, the combination of conspicuousness of consumption as well as an aversion to taking a risk on an unfamiliar product (such as infant formula, pet food, and consumer health), are two factors that make brand recognition highly influential in the purchasing decision and keep pricing power strong.

What types of consumer staples products are increasing in demand? What types are decreasing? 

Products that afford consumers added convenience, and/or those with a health and wellness bent (including organics and snacking) have seen increased demand. Two categories that have succumbed to weakening demand include cereal and soup.

I know that currently many consumers are more conscious about a company’s impact on the world, for example in green energy. Do you think consumers are just as interested in socially responsible products for more day to day products too? 

I think that this varies by product and by consumer.

Do you have any examples of companies that are navigating these challenges particularly well?

If you are referencing the challenges constraining consumer product firms across the board (particularly as it relates to sluggish top-line performance), I would highlight McCormick. For instance, McCormick again bucked the trend of stagnant sales plaguing industry operators, boasting a 2.7% organic top-line increase in its recently reported second quarter (primarily the result of higher volumes). We view this uptick even more favorably, given it came on top of 4.5% growth a year ago. Management attributed this to distribution wins, particularly on its home turf, for its recently acquired French’s and Frank’s lineups. We think this speaks to the entrenched edge McCormick has amassed with leading retailers. In our view, this standing creates a virtuous cycle, starting with scale, affording manufacturers a mutually beneficial relationship with retailers, through which the vendor is an important retail partner, developing sales strategies to maximize volumes and retailers’ margins, while also prioritizing its own brands. As such, while intense competitive pressure (from other branded operators, small niche peers that have proved more agile in responding to evolving consumer trends, and lower-priced private-label fare) is likely to persist, we believe McCormick will be able to withstand these challenges longer term because of its solid competitive positioning. We’re also encouraged that despite inflationary pressures (input, transportation, and logistics), McCormick chalked up 340 basis points of gross margin improvement to 43.3% and 330 basis points of adjusted operating margin expansion to 15.6%. These heightened profits came even in the face of a 16% increase in brand marketing spending. We surmise these resources support the firm’s standing with retailers as well as its portfolio of leading brands.

Thank you to Erin Lash for taking her time to answer all of my questions. My main take-aways are that it is important to find companies capable of withstanding the changing times. Generations all have different values when it comes to what they are willing to fill their house with, and it is important to watch the patterns of the consumers. Companies that have strong moats are able to thrive in an otherwise difficult market.

If you have not already, you can check out my book, Early Bird: The Power of Investing Young, on Amazon!

Article by Compounding Snowballs


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